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Moral hazard is the incentive of a person to use more resources than he otherwise would have used, because someone else will provide these resources, against his will, and is unable to immediately sanction this expropriation.[1]

Examples

Automobile insurance creates a moral hazard for drivers; it creates an additional incentive for risky driving because other insurance clients will pay a part of the costs of the driver's accidents. Similarly, in the presence of unemployment insurance, an unemployed person has an additional incentive to stay unemployed because other people will pay at least a part of his living expenses. Or, in the presence of health insurance, insured people will have an additional incentive to engage in risky activities or lifestyles because others will pay at least a part of the treatment in case of illness or accidents.

Employees can be subject to moral hazard to the extent that they can reduce their efforts without fearing reduced pay. Debtors may be subject to moral hazard if they believe they can squander the money without negative consequences when they turn out to be incapable of paying back. Certain auditing firms have been subject to moral hazard when they sold consulting services to the very companies they were supposed to audit (for example, in the Enron case). A central bank can produce moral hazard in the banking community if the commercial bankers perceive the central bank as a lender of last resort. The IMF can produce moral hazard among debtor governments. Taxpayers are said to be subject to moral hazard if they can evade high-tax regions, and so on. Similarly, in the literature on public choice and constitutional political economy, governments and parliaments are often portrayed as agents prone to moral hazard, whereas the voters are the less informed principals.[1]

Conventional theory

Conventional economic theory explains moral hazard as a consequence of the fact that market participants are unequally well informed about economic reality. In other words, it results from "asymmetries of information" and the theory of moral hazard is therefore considered to be a part of the economics of information. The other condition is the separation of ownership and control.

In a co-ownership, if one co-owner of a swimming pool cannot effectively monitor the activities of his fellow-owners, the latter have an incentive to swim without cleaning up, repairing the fences and so on, thus increasing their own (monetary and psychic) income at his expense. In the Principal-agent problem, when the principal cannot effectively monitor the activities of his agent, the latter has an incentive to increase his own (monetary and psychic) income at the expense of the former.[1]

Moral hazard in the free market

In a free market, a property owner can use his property as he sees fit, including the (voluntary) separation of ownership and control. Moral hazard, even with asymmetric information, leads to a systematic expropriation only when the ownership and control of a resource are separated without the consent of the owner.

Information asymmetries are a universal aspect of human life, so moral hazard is not a market failure, but an unavoidable risk. The real key is the role of expectations and good judgment. To the extent that the expectations of the principal are correct, moral hazard on the part of the agent cannot lead to a situation where he could enrich himself at the other party's expense.

Payment to new employees is lowered by a factor that represents the risk of bad work due to lack of supervision.

Design contractual relationships to minimize (a) the danger of moral hazard arising in the first place and (b) the danger of moral hazard, once there, affecting them negatively. In health insurance, for example, exclusions, deductibles, and copayments are tools intended to reduce moral hazard. Similarly, moral hazard in road traffic has been effectively reduced with the help of radar controls and black boxes in vehicles.

On a free market, principals can sever contractual relations with agents at any time. The threat of being fired is probably the most powerful incentive to deliver diligent work rather than succumb to moral hazard.

In co-ownerships, the co-owners have an incentive to set up and accept rules for its use. If the number of co-owners is high, individual capitalist-entrepreneurs might step in and provide the co-property and the rules, as for example in urban development.

the buyer-beware doctrine, where buyers accept greater risk in return for a lower purchase price. The buyers will tend to be careful about what they buy. This intensifies entrepreneurial competition over market share by making reputation all the more important. Consumers act as monitors to ferret out bad sellers; at some cost as the shopping takes more time and effort.

Warranties, guaranties, refunds and other forms of product insurance to compensate consumers when problems arise with the products they purchased. Of course, the supply of such insurance entails real costs. Which method is chosen depends on the entrepreneurs, and ultimately, on what consumers are willing to pay. At a high enough price, they will bear additional risk concerning the products they buy.

Further, the principal-agent problem inherent in any hierarchy is less pronounced in the private sector than it is in the government. Executives and mid-level managers who mismanage the money can be fired and replaced without too much difficulty. It is much more difficult to get rid of politicians and bureaucrats, who have vague objectives and who cannot engage in rational economic calculation because they are not disciplined by prices, profits, and losses.[3]

Unclear property rights

For a great number of economic goods there are no clearly defined property rights. The air and oceans and their inhabitants, birds and fish, are often considered to be the commonwealth of humanity. Human beings appropriate these resources with weak attempts at creating something like property rights, a system of co-ownership without rules. Not surprisingly, the result is universal moral hazard; everybody has an incentive to use the resource in question as much as possible. This is a sure recipe for quick depletion, as has been known at least from the times of Aristotle. The phenomenon is known as "tragedy of the commons."

Note, in this highly important case, information asymmetries play no role. Moral hazard would be at work even if each co-owner were perfectly aware of the activities of his fellow owners. It can be argued, that moral hazard could have an even larger effect.[1]

Moral hazard in Interventions

Moral hazard may be some risk in general, but has the greatest effect if ownership and control are separated by force, i.e. against the owner's will. Although owners might be forced both by governments and by private parties, government interventionism is far more important in practice. A government can command property owners to use their resources in a different way than these owners would have used them. And so, the government makes some person or group (for example itself) the uninvited co-owner of other people's property. This is the essence of interventions: institutionalized uninvited co-ownership.

The basic types of interventions are:

Taxation, where the government proclaims itself the owner of (a part of) resources belonging to its subjects; and forces them to eventually hand them over. Today taxation does not concern concrete physical items, but their monetary equivalent; so until the tax is paid, the government imposes itself as the co-owner of virtually all physical assets of the taxpayers.

Regulation means that the government proscribes a certain use of certain resources, typically not a use the citizens would have chosen (it would be pointless otherwise). Again, the government proclaims itself the co-owner of these resources. An example are price controls. If the government fixes a minimum wage rate, it effectively proclaims itself the co-owner of workers, because it does not allow them to work under conditions they see fit. And it also proclaims itself the co-owner of the capitalists or, more precisely, of the money that the latter plan to spend on labor.

Prohibition means that the government outlaws a certain use of certain resources. Again, it proclaims itself the co-owner of all resources that could be put to the prohibited use. For example, if it can prohibit the production and sale of alcoholic beverages.

The citizens still have ownership and control of their property, but they have to share them to a degree with the government and its agents. Increased interventionism increases the share of government control of resources, without outlawing other people's simultaneous control of these same resources. But the forced nature of the co-ownership itself is not a matter of degree. It is a categorical and essential feature of any intervention.

Since government interventions always force a separation of ownership and control, they create a moral hazard for the citizens and for the government. Most importantly, it creates a situation in which each of the parties involved (the citizens on the one hand and the government on the other hand) desires to expropriate the resources subject to interventionism at the expense of the other parties.

As intervention entails forced co-ownership, it follows that the citizens have an incentive to evade the intervention. To avoid taxes, for example, they can choose to invest capital in a country with low taxes rather than in a country with high taxes; they can choose to emigrate to low-tax countries rather than stay in high-tax places; they can choose a profession that is less taxed than other professions; or they can choose to make fraudulent declarations of their income and capital. To evade regulations, they can choose not to buy or sell commodities subject to price controls, or they can choose to buy and sell them on the black market. To evade prohibitions, they can buy and sell prohibited items on the black market. But these evasions can be risky and very costly. Therefore, there is an incentive to use a greater part of property for personal consumption rather than investment. The general tendency of interventions is towards excessive consumption and more expensive production because of the necessity to evade the intervention.

But moral hazard also comes into play on the side of the government. Governments rely on the resources from taxes and regulations. They will therefore tend to tax more and regulate more to neutralize the ways in which the citizens evaded its previous intervention, to "close the loopholes." This is the basic mechanism of government interventions. Interventionist governments have an incentive to extend taxation to all branches of economic life; to regulate industries that have so far escaped regulation; and to beat into submission the countries that serve as tax havens. The ultimate result is to reinforce the tendencies of excessive consumption and insufficient production; in short, a general impoverishment of society.

Notice that this does not depend on the existence of asymmetrical information. We can assume for the sake of argument that all citizens are perfectly aware of the government's activities, and that the government is also perfectly well informed about the activities of all citizens. All of this would not alter the picture. Government interventionism entails moral hazard both on the side of the government and on the side of the citizens. It cannot be neutralized by choosing appropriate contractual devices, because it has no contractual basis at all; it is imposed. It cannot be sidestepped by choosing to avoid the moral-hazard-prone situation altogether, because the situation itself is imposed. The very meaning of interventionism is to overrule the choices of property owners.

And similarly, the workings of moral hazard cannot be eliminated or diminished by correct expectations, as in the case of moral hazard on the free market. It is precisely when the citizens correctly anticipate how high the next tax will be, and when it will hit them, that a moral hazard will incite them even more to evade the tax.[1]

Moral hazard in monetary policy

A fundamental intervention is the imposition of a legal tender, forcing market participants to use a certain means of payment. This creates a moral hazard to hoard or export the media of exchange that seem better than the legal tender. The paradoxical result is that only the legal tender — the medium of exchange that everybody seeks to avoid — remains in circulation. This is called "Gresham's Law."

Fiat money creates moral hazard for its producer because he has the possibility of creating virtually any amount of money and to buy virtually any amount of goods and services for sale. The only limit to this capacity is the hyperinflation that invariably results in the case of a great inflation of the money supply.

But fiat paper money also creates moral hazard for the money users — the citizens, the banks, and the governments — because they sooner or later realize that the masters of the printing press have the power to bail out any bankrupt firm or government. They engage in reckless financial planning, expecting that the monetary authorities will not allow too many reckless planners to go bankrupt. This speculation has been borne out by the last thirty years. Public and private debts are at record heights all over the world.

These dangers were long known to monetary theorists and defenders of sound money. But neither has the problem escaped the attention of the champions of fiat money. Nineteenth-century economist Walter Bagehot, who coined the term "lender of last resort," warned that the central bank, while freely lending in times of financial duress, would have to avoid at any cost the impression that it would bail out the market participants. Some sixty years later, Herbert Simon stressed the need for rules rather than discretion in economic policy, essentially for the same reasons. And his disciple Milton Friedman reiterated this point even more famously in his proposal for a constant growth rate of the money supply.

But how can rules prevent large-scale moral hazard in a fiat paper money system? How can be this power handled responsibly? In analogy to a phrase from Anthony de Jasay, it is like using a chastity belt for Miss World while letting her keep the key. To make the analogy with our monetary constitution perfect, we would have to advertise day in day out that Miss World definitely owns the key to her chastity belt.

If more or less every major participant to the financial market is subject to moral hazard, then in due time even the smaller traders realize that and they too set out on the same path. Financial bubbles are the unavoidable result. Sooner or later, the market participants come to base their plans on the availability of a far greater quantity of goods and services than is really available in the economy. In short, paper money by virtue of its mere existence produces massive error on a large scale, until the bubble bursts in a crisis. Again, these effects cannot be neutralized, avoided, or diminished through anticipations.[1]